Entrepreneurs: Don’t Fall Into the Equity Trap!

The issue of equity at a startup company is always a sensitive one, and it is rarely handled properly. The most common way, and probably most destructive, is to split the equity evenly among the founders. So, for instance, two founders would get 50% each and three founders would get 33.3% each.

The problem with the equal split is that most people don’t put exactly the same amount of effort or add exactly the same amount of value to the organization. So, when some people work really hard and others work less hard, tensions rise and resentment soils otherwise good relationships. As the needs of the company grow and change, more people may need to be added. Sooner or later, the team will have to reevaluate the distribution of the equity when they realize that the equal splits just didn’t make sense. These conversations are fraught with danger. Missteps can destroy a good company and scare off potential investors and employees.

The Greedy Bone

This “equal-equity” trap is caused by hopeful thinking instead of practical thinking. Founders think about the millions of dollars that they will certainly make, and the “Greedy Bone” kicks in. Founders figure this is their last chance to get the best deal possible and they want to maximize their portion without appearing to be greedy or selfish to the other members of the team. So, splitting it equally is the easiest solution.

A Better Way

The better way is not to worry so much about the future value, but instead, consider the current value of the various inputs into the company. For instance, if a founder leaves her job to start a company, she is forgoing a salary and assuming the risk that she may never get paid. So, the current value is the opportunity cost of not getting a salary, plus a premium for the risk.

Or, if a founder invests his cash into the company he assumes the risk of never getting it back. So, the value of the input (time or money in this case) is the opportunity cost plus a risk premium. Relative to time, cash is more valuable because it’s harder to save $1,000 than it is to earn $1,000 so it deserves a higher risk premium.

Let’s set the risk premium for the salary at 200%. In other words, if you risk your salary now, the company will pay you twice your salary when it has the cash. This is a pretty good deal that most people would be happy to take. If the company, on the other hand, can actually afford to pay you your salary, there is no risk – and therefore, no equity.

Consider the cash. For an early-stage company, risk is very high, so let’s set the risk premium at 400%. So, when the company liquidates you will get four times your money back. Not a bad return.

Of course, these are pretend values. The company makes no guarantees, and the likelihood of paying out exactly 200% on the salary, for instance, is low. You may get less, but hopefully you will make more. However, by calculating this pretend value, we better understand the value of each other’s inputs relative to each other. No matter what the splits are, founders and investors should be happy if they get back a proportion that is equal to the relative value that they put in. In other words, say you provide 80% of the inputs; you would expect to get 80% of the reward. Inputs include: time, money, supplies, ideas, and a variety of other things that turn an idea into reality. All of these things have a current value.

I created a mechanism for tracking the various inputs made by founders and early participants. It’s called a Grunt Fund and it allows individuals to earn equity on a rolling basis during the early stages of a start-ups life. This allows for the changes in a new company and the people who work on it. The advantage is that founders will avoid the risk of making equity-allocation mistakes, while providing incentives for each other to contribute. If some people work harder or provide more value in other ways, they will be rewarded in a way that is perfectly fair to their teammates. Additionally, it allows the company to add or subtract team members as needed.

Dividing the pie equally among founders in an attempt to get the largest possible slice of some future value almost always leads to trouble. But, if each founder gets back an amount that reflects the relative value of what they put in, everyone should be satisfied (except the greedy ones who want more than their fair share).

To learn more about the Grunt Fund and how to use it, visit SlicingPie.com